When Audax Group raised $1.7 billion for its so-called "continuation fund" in January, it joined a growing list of PE houses that have started creating liquidity by buying their own portfolio companies. 

Boston-based Audax's new vehicle bought assets from Audax Private Equity Fund IV, a 2012 vintage fund that launched with $1.25 billion in commitments. Among the assets it purchased were chemicals specialist ICP Group and 42 North Dental, a New England-based company that manages dental practices.

Put simply, continuation funds are a rebranding of general partner-led secondaries. The purpose is twofold: to hold onto investments in the hope of making bigger returns at a later date, and to provide a potential exit for LPs. Other firms that have recently jumped on this trend are BC Partners, which reportedly had plans to roll publisher Springer Nature into a new vehicle in December, and Ampersand Capital Partners, which raised $670 million in November for a continuation fund to buy three assets from a legacy fund. 

What is a continuation fund?

A continuation fund is a new vehicle that is set up to take on the portfolio investments of a fund that is nearing the end of its lifespan. Traditionally, LPs will invest in a fund with the understanding that they will see a return in around 10 years. However, when a GP wants to hold on to portfolio assets for longer, that promise becomes harder to fulfill. By setting up this new fund, LPs are given the option to cash out, or to stay invested in the portfolio and recommit to a new vehicle.

Such deals aren't an entirely new concept, but their wider acceptance under the label of "continuation funds" is notable because they give PE firms more wiggle room to hold on to companies longer. They are also expected to gain popularity at a time when many funds, reeling from the impact of the pandemic, are looking for new ways to offer their investors liquidity.

"Given the crazy dislocations of the last year, there will be both strong assets that GPs may not want to exit yet, and weaker assets that have had a bad time but have strong fundamentals and therefore need more runway," said Katherine Ashton, a London-based partner with law firm Debevoise & Plimpton who specializes in secondaries.
 
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Did the pandemic make continuation funds more attractive?

Not all continuation funds are the result of the past year's unique volatility. 

Don Bramley, a managing director at Audax, said his firm had already started planning for their continuation fund back in 2019. The more significant theme for him is the change in the way GP-led secondaries are perceived. Once denigrated as a means of restructuring troubled private funds, continuation funds are now seen as an effective tool for proactive fund management. 

"Today, the stigma is gone around these kinds of transactions," said Hani El Khoury, an investment principal with Coller Capital. "It's more of a case of GPs catching up with this market and really realizing the value that the secondary market can bring to the portfolio, to their investors, and to themselves." Coller was the lead investor in one of the first transactions to start the trend: Nordic Capital's €2.5 billion (around $3 billion) continuation fund, which closed in 2018. 

How many PE firms are using GP-led continuation deals?

According to El Khoury, the majority of blue-chip private equity firms have either considered a GP-led transaction or have already completed one. He cited Coller Capital data showing the whole secondaries market traded about $60 billion in volume last year, and around 50% of those transactions were GP-led. El Khoury expects secondaries volume in 2021 to be much higher than last year, with GP-led transactions making up a large share of the total.

There is also a lot of dry powder. While the number of secondary funds that closed in 2020 was down from the previous year—29 compared with 44 in 2019—a record $96.6 billion in new secondary funds was amassed, according to PitchBook data. More than half of that capital was raised by Ardian, HarbourVest Partners, and Lexington Partners. Lexington was a lead investor in Audax's debut continuation fund. 

However, while a continuation fund can be an attractive solution it can also be complex. 

Debevoise's Ashton noted that no two transactions are the same and each is tailored to the needs of a particular situation. In some cases, several portfolio companies will be transferred to the continuation fund, while others will involve strip sales in which the fund manager sells parts of different assets to the new vehicle. The GPs must also balance the interest of multiple stakeholders. 

"The private equity house is deeply conflicted because it has a duty as the manager of the old fund, but it's also managing the new fund for the benefit of both the old investors and the new investors," Ashton explained. "So while it is very similar in ways to a traditional M&A process, it's also very similar to the sort of fund level negotiations where you're building an ongoing relationship."

In some cases, the terms of the original limited partners' agreement will also change. Coller's El Khoury notes that there is a slight difference between LPs who rollover and those who reinvest. The former consists of existing LPs who will have a status quo option to reinvest under the same terms of the legacy fund, while the latter will effectively be exiting the old fund and making a decision on whether they want to reinvest in the new fund.    

"You've got to set a price that's good enough that the people who want to cash out feel that they're getting value," added Ashton. "If it's too low, they'll say: 'This isn't worth it.' But you also have to set a price that's not so high that new money doesn't want to come in."

While they can be difficult in execution, Audax's Bramley maintains that continuation funds are a tool that's going to be used a lot more in the future by GPs, especially given the vast sums of capital being raised. 

"Those capital pools have grown over the years and the sophistication around these types of transactions has grown," Bramley said.  "They're providing a lot of flexibility for GPs and I think it's a growing market and a substantial opportunity for all those who are participating."

Featured image by C.J. Burton/Getty Images

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